QUARTERLY LETTER

Published Fourth Quarter 1993
Muhlenkamp Memorandum 28

The trends we have been discussing over the past few years remain in place. The next interesting question will come up a year when it becomes apparent that President Clinton's program is neither lowering unemployment nor reducing the deficit. Meanwhile, stocks are fulfilling our expectations of 10% per year -- we are doing much better -- and long-term interest rates have returned to normal. I repeat - long-term interest rates have returned to normal. This followed 12 years in which real interest rates (interest rates over inflation) were unusually high, which followed 15 years in which real rates were unusually low. We believe both anomalies occurred because the public was very slow to recognize the dramatic increase in inflation in the late '60s and the subsequent decrease in inflation in the early '80s.

One consequence of the decline in interest rates is that there is no longer any basis for thinking stocks are "overvalued." Let me explain. The models that seek to determine fair value for stocks use corporate earnings and a capitalization rate (such as a price/earnings ratio) to arrive at "fair value." Nearly all such models use interest rates to set the capitalization rate. Current interest rates are assumed to be fair. Interest rates themselves are never viewed as "too high" or "too low." (When I was doing basic evaluation work 20 years ago, I initially made the same assumption, but soon found it to be a mistake. I then learned that fair values are determined by inflation and that interest rates suffered from the same emotional swings that stock prices do.) For the past 12 years, stocks have been viewed as "too high" in relation to interest rates. In reality, interest rates have been too high. When short-term rates fell in 1990-1991, the models that used short-term rates as a base started to show that stocks were fairly priced. As long-term rates have fallen over the past few months, the models that use long-term rates as a base have begun to show that stocks are fairly priced. One database that we purchase, Ford Investor Services, Inc., calculates a price/value ratio for 2000 stocks based on long-term bond rates. Ford's price/value ratio fell below 1.0 (indicating prices are fair value) in August 1993 for the first time since July of 1980 (except for a brief period during the Gulf War.) During much of the 1980s stock prices frequently bottomed at a price/value ratio of 1.2. At those levels, the model said that stocks were 20% overpriced, but the reality was that interest rates were too high; stocks were a good buy.

Today, we are told that interest rates are "too low" and stock prices are "too high" but the period used for comparison is one of high inflation. By the guidelines we derived 20 years ago, (when inflation was rising and interest rates were considered "too high" and stocks prices "too low") at the current level of GDP and corporate profits, bond prices have finally returned to "fair," and stocks prices are "fair" for inflation of 3-4% -- which is where we are. Because markets are people and people are emotional, you can get a 10% move (in either direction) at any time. But these swings usually neutralize in less than three years (see charts 1-4.).

We are not arguing that stocks are cheap. We are arguing that stock prices are fair.

We do think you should:

• Beware of Good yields -- as we spelled out in Newsletter #26.
  
• Beware of fixed annuities. "Fixed" does not mean the rate is fixed. If you have owned an annuity for five years, you have seen the rate fall from 9% to 6% -- and it will fall further. Because we expect few people to heed this warning, we are happy to own stocks in the companies and the brokers who are selling annuities.
  
• Beware of life insurance: Again, the rate is not fixed. If you bought a policy five years ago, you have seen the premium (or the number of premiums) go up. It will happen again.
  
• Beware especially of international investing. All the things you are told about growth and declining interest rates outside the U.S. may be true. But they are likely to be negated by a stronger dollar. If you don't understand the last sentence, you have no business investing internationally. Yes, I know all the publications encourage it -- all the more reason to follow John Templeton's lead and pull your money out of overpriced foreign investments. (See the Wall Street Journal 9/22/93).

Read our quarterly newsletter, Muhlenkamp Memorandum, for more by Ron Muhlenkamp.